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I have a new paper out with the Mercatus Center on prediction markets that you can find here. Much has been written about these markets, but I think critics are often thinking about this incorrectly. The most important thing that is missing from the discussion is this: to the extent that market inefficiencies have occurred in modern prediction markets, it is difficult to disentangle these outcomes from the limitations on these markets created by the restrictive legal environment they have operated in.

The existing evidence is positive about these markets as forecasting and information aggregation tools. But when looking at examples where these markets have underperformed we should really remember that even when Intrade was operating legally there were significant regulatory restrictions placed upon it, and most participants were operating in a gray market at best. For example, in a rule many were clearly ignoring, the CFTC technically required all participants to have assets of more than $5 million to $10 million. Another example is the popular Iowa Exchange Market, which is limited to "academic" traders who can make a maximum investment of $500.

As a result, far too much judgement of the efficacy of these markets ignores that fact that most existing data has been generated in fraught legal environments. Instead, we should consider this correct observation from prediction market critic Barry Ritholz:

The difference between the Bond market and say, the Iowa Electronic Markets, NewsFutures and the Hollywood Stock Exchange or Trade Sports is in the size, scale, and liquidity.

Combined with the fact that the size, scale, and liquidity are in part a function of the stifling regulatory climate, and that the evidence has so far been fairly good, we should remain optimistic about the potential of these markets.